Many tax jurisdictions including Hong Kong have entered into Comprehensive Double Taxation Agreements/Arrangements (DTAs) with one another. These DTAs protect taxpayers from paying double taxation in different jurisdictions and provide certain tax benefits to the taxpayer. However, the application of such DTA benefits is often not that straightforward.
Hong Kong Certificate of Resident Status
Currently, Hong Kong has entered into DTAs with 40 jurisdictions (including the Mainland) under which a Hong Kong tax resident is potentially entitled to tax benefits, such as preferential withholding tax rates in respect of payments on dividends, interest and royalties charged by Hong Kong’s DTA partners. Under the arrangement with the Mainland, Hong Kong companies might be able to enjoy preferential DTA rates on various China sources of income if they are Hong Kong tax residents. A Certificate of Resident Status (CoR) issued by the Inland Revenue Department (IRD) serves as a proof of the Hong Kong tax resident status under DTAs.
In general, the following parties can apply for a CoR from the IRD:
- An individual who ordinarily resides in Hong Kong;
- An individual who stays in Hong Kong for more than 180 days during a year of assessment or for more than 300 days in two consecutive years of assessment, one of which is the relevant year of assessment;
- A company, partnership, trust or body of persons incorporated or constituted outside Hong Kong but managed or controlled in Hong Kong.
It is interesting to note that although companies incorporated in Hong Kong are eligible to apply for a CoR, their applications are not always successful. This is because the IRD will assess, on a high-level basis, whether the applicant should be entitled to treaty benefits. From our experience, IRD assessments tend to focus on the following factors:
- Whether the directors and senior management of the company principally reside in Hong Kong,
- Whether the applicant has employees in Hong Kong and whether remuneration is reported in the Employer’s Returns to the IRD;
- Whether there is active business income derived from and taxable in Hong Kong; and
- Whether the applicant has a physical office or fixed place of business in Hong Kong.
If the IRD believes a person would not be entitled to the treaty benefits, it may request further information or exchange information with the other treaty partner before deciding whether a CoR can be issued. The IRD would reject a CoR application if it is clear that the applicant should not be entitled to those benefits.
At present, there are no clear guidelines in relation to these factors, e.g. number of senior management based in Hong Kong and the number of days they spend here, or the amount of Hong Kong sourced income, etc. However, even if the CoR applicant is relatively “light” in certain areas (such as having no active business income derived from Hong Kong), the applicant can still present their case to the IRD to demonstrate their substance and economic activities in Hong Kong.
While there is no formal objection or appeal mechanism available for applicant to escalate cases when the IRD refuses to issue a CoR, according to the 2018 annual meeting between the IRD and the Hong Kong Institute of CPAs, the IRD advised that the rejected applicant can contact the IRD case officer. The applicant should submit further information and documents for the IRD’s reconsideration. If the case officer maintains their decision, the applicant can request the case be reviewed by the Chief Assessor of the Tax Treaty Section. However, this time, with no guarantee of success, means that applicants should ensure they present all relevant facts to support their application.
A CoR serves as proof of the applicant’s Hong Kong tax resident status for the calendar year covered by the CoR and two succeeding calendar years under the DTA with the Mainland – unless there are changes in the circumstances of the Hong Kong resident such that their conditions for enjoying the tax benefits are no longer met.
Next step – beneficial ownership
To enjoy treaty benefits under the DTA, Hong Kong companies are required to present a CoR and be the beneficial owner (BO) of the related income. In simple terms, a BO is a person who has the right of ownership and control over income or the usage right or ownership of the source of the income.
Determination of a BO may require some detailed analysis of the operational structure and how they map with the requirements under the relevant tax regulations. Since 2009, the Mainland State Administration of Taxation (SAT) has issued several sets of guidance, including the Guo Shui Han [2009] No. 601 (Circular 601) and Bulletin of the SAT [2012] No. 30 (Bulletin 30), to lay the framework for BO determination, e.g., detailing the qualification requirements for beneficial ownership status and introduction of the safe harbour rule for listed companies.
On 3 February 2018, SAT published Bulletin [2018] No. 9 (Bulletin 9) to repeal Circular 601 and Bulletin 30, and provide clearer guidance for BO determination. Bulletin 9 applies to tax payments or withholding obligations that arise on or after 1 April 2018.
Assessment based on negative factors
Bulletin 9 sets out a list of negative factors to assist Mainland tax officials in assessing whether an applicant can be regarded as the BO of income. Existence of any one of the five negative factors below would see the applicant not qualify as the BO of the income:
- The recipient is obligated to pay or has actually paid more than 50 percent of the income to a resident(s) of a third jurisdiction within 12 months of receiving it.
- The business activities carried out by the recipient of the income do not qualify as substantive business activities (i.e. substantive manufacturing, trading and management activities, investment management, etc.).
- The relevant income is exempt from tax or not taxable in the jurisdiction of residence, or if the income is taxable, the effective tax rate is extremely low.
- In addition to a loan agreement under which interest arises and is paid, the creditor has concluded another loan agreement or deposit agreement on similar terms with a third party.
- A license or transfer agreement exists between the non-resident and a third party relating to the right to use, or the transfer of the ownership of, the copyright, patent or technology covered by a license agreement, based on which a royalty is derived and paid.
It is worth noting that there is uncertainty concerning beneficial ownership status as certain judgment is still required, particularly regarding what constitutes “substantive business activities,” and thus the entitlement to DTA benefits.
Safe harbour rules
Companies that can apply the “safe harbour rules” will automatically be considered by Mainland tax officials as BOs of income without undertaking the comprehensive assessment of negative factors above. The “safe harbour rules” provide a high degree of certainty for applicants. However, they only apply to a very specific group (such as government, individuals or companies listed in another jurisdiction) on their Mainland China-sourced dividend income. There must also be shareholding continuity in the 12 months before receiving the dividends. Due to these stringent qualifying conditions, application of the “safe harbour rules” is rather limited in practice.
Look-through rules
Bulletin 9 introduced the “look-through rules” for recipients with multi-tier holding structures. In essence, as long as there is a BO in a multi-tier holding structure, Mainland tax authorities will “look through” the structure and treat the intermediate companies as the BOs if certain qualifying conditions are met. “Look-through rules” recognize companies that are receiving Mainland-sourced dividends as the BOs of such dividends even if they could not qualify as BOs on their own and the “safe harbour rules” do not apply.
The following example is a good illustration of the application of the complicated “look-through rules”:
A Mainland China company is held by a Hong Kong tax resident (Co. A, which is a Hong Kong CoR holder), which in turn is held by another Hong Kong or BVI company (Co. B, without a Hong Kong CoR), itself held by a listed company in Hong Kong (Listco, with a Hong Kong CoR). Both Co. A and Co. B are investment holding companies without any substantive operations. Co. A would like to apply for treaty benefits on their Mainland China sourced dividend income.
In this example, which is very common in Hong Kong, the Mainland company is held by a Listco via intermediate investment holding companies with minimal business activities. Prima facie, Chinese tax authorities will not accept Co. A as the BO of the dividend income.
However, under this structure, Listco would be regarded as the BO of the dividend income automatically under the “safe harbour rules,” provided that Co. A is 100 percent held by the Listco (directly or indirectly) in the 12 months before it received the dividends. “Look-through rules” apply and Co. A would be regarded as the BO and enjoy DTA benefits even though it could not satisfy the BO qualifying conditions on its own.
The “look through rules” significantly broaden the population eligible to the treaty benefits. As the application of “look through rules” also eliminates the uncertainty of BO assessments, taxpayers should determine if they can apply these rules when claiming their treaty benefit or consider restructuring the holding structure such that these rules would then apply.
Key takeaways
It is worth noting that the issuance of a CoR does not guarantee treaty benefit entitlements under the Mainland-Hong Kong DTA. It is the decision of the Mainland tax authorities whether the applicants can enjoy treaty benefits.
For instance, the applicant is still subject to the BO test in the Mainland under Bulletin 9 and has to follow the administrative procedures set out by the tax authorities. Even if the recipient of the Mainland-sourced income is considered as the BO of the income, tax authorities can still invoke the main purpose test under the tax treaty or the general anti-avoidance rule in the domestic tax law to deny treaty benefits.
Entities should conduct a thorough review and assessment of their BO status with reference to the latest requirements under the safe harbour or look-through rules and consider modification of their holding structures to help secure treaty benefit entitlements.
Polly Wan is Tax Partner and Angela Chan is Tax Manager at Deloitte China
